Revisiting value investing through first principles?
A= P*(1+R)^N
-always increase P. Initially, your ability to save and invest will impact A more than R/N. Impact of savings would reduce over time as networth increases.
- try for R through capital allocation, however N is in your hands more than R
Q1. What is the value or worth of a company?
Ans. Value of a company is the present value of the future free cash flows plus the cash it has on its books
In simple words, Equity Value = Enterprise Value + Net Cash
Where, Enterprise Value = Net Present Value of future cash flows discounted at Cost of Capital
For equity investors, Equity Value per share or simply the Share Price is more important than total Equity Value
Q2. So based on the above, how to select companies for investment
Ans. Buy companies where the following two conditions are met:
a) Companies are trading at less than their Equity Value, and
b) Equity Value is growing
of the two conditions above, b) is more important than a) if shares are to held for a longer time as stocks can remain undervalued for a long time or even if a share is bought at a higher price then increasing Equity Value would eventually catch up and then exceed the purchase price, eventually leading to appreciation of the trading value of the shares
Q3. How to identify companies where Equity Value is likely to grow?
Ans. The following conditions are ideal for growth in Equity Value
a) Is the company in a large and growing market? if the market is not growing the growth is limited and competitive intensity may be increasing. Large growing market creates long runway for growth
b) Is the company growing and ideally faster than the market? Select growth companies that are gaining market share or in other words growing faster than the growth in the market
c) Does the business generate FCF? FCF is generated when ROCE > Growth Rate - so high ROCE is important. If there are not FCF business would have to either dilute equity or increase debt to support growth. Beyond a point growth is constrained (if no capital raised) or risk is increased (debt) or EPS growth is diluted (raise fresh equity)
d) Is company able to reinvest money at high growth rates? This is key to compounding and therefore high returns. Company should be able to reinvest the cash generated into the business while maintaining ROCE on the total invested capital
e) Is the quality of business high? One way to judge that would be to compare gross margins with competitors - companies with high gross margins tend to have better products where customers pay a premium or have cost structure that is lower than competitors so then tend to retain gross margins - in other word they have a MOAT.
f) Management Quality - More on that later
Basics, hygiene: Clean accounts, Clean management, Incentives aligned with minority investors
Some Market Maxims
- Buy Low - Sell High : make Mr market work for you. Market is going to offer mis-priced quotes from time to time. Only buy if market offers quote below intrinsic value and sell if quote is above intrinsic value
- Value is created by future free Cash flows and growth in future free cash flows, discounted by risk adjusted discount rate
- FCF comes from ROCE > Growth Rate
- Growth comes from reinvestment, capital allocation, long runway of growth, differentiation, quality of operators
- Growth = Reinvestment Rate *ROCE: focus on high ROCE companies
- Reduce risk: track record, mgmt, competition
- However given the volatility and difficulty in forecasting businesses
- Markets often mis-price businesses (variety of reasons).
- Buy when upside risk is high and downside risk is low
- Buy deep value (Below cash + profitable business attached) - Valuation catches up eventually if management treat minority investors equitably
- Buy growing businesses at low/reasonable valuation
